Tax Court Declines to Follow Rev. Rul. 91-32

For more than 25 years the IRS has maintained that gain on a foreign partner’s disposition of an interest in a partnership that conducts business in the U.S. is subject to U.S. tax. To arrive at this conclusion, the IRS applied the “aggregate theory” of partnerships for the disposition of the partnership interest. In Grecian, the Tax Court held that the “entity theory” of partnerships should apply when a foreign partner disposes of an interest in a partnership that conducts business in the U.S. The result of applying the entity theory is that the gain on the disposition of the partnership is not subject to U.S. tax.

Summary of the Case

In 2001, GMM, a foreign corporation, purchased an interest in Premier, a U.S. limited liability company that was treated as a partnership for U.S. income tax purposes. From 2001 to 2008 income was allocated to GMM from Premier, and GMM paid income tax in the U.S. In 2008 GMM's interest was redeemed by Premier, and GMM received two liquidating payments, one in July 2008 and the second in January 2009. GMM realized gain totaling over $6.2 million, of which $2.2 million was deemed attributable to U.S. real property interests (which GMM conceded was taxable under the FIRPTA rules of Code §897(g)).

The court held that the non-FIRPTA portion of the gain ($4 million, referred to by the court as the "disputed gain") was capital gain that was not U.S. source income. As a result, the disputed gain was not effectively connected with a U.S. trade or business and was not subject to U.S. income tax. The court applied the "entity theory" (as opposed to the "aggregate theory") with respect to the sale or exchange of the interest in the partnership. The court declined to follow Rev. Rul. 91-32.

In discussing Rev. Rul. 91-32, the court stated:

Rev. Rul. 91-32 is not simply an interpretation of the IRS's own ambiguous regulations, and we find that it lacks the power to persuade. Its treatment of the partnership provisions discussed above in part II.B is cursory in the extreme, not even citing section 731 (which, as we set out, yields a conclusion of “gain or loss from the sale or exchange of the partnership interest” * * *. The ruling's subchapter K analysis essentially begins and ends with the observation that “[s]ubchapter K of the Code is a blend of aggregate and entity treatment for partners and partnerships.” We criticize the ruling's treatment of the subchapter N issues in notes 22 and 24 below. We decline to defer to the ruling. We will instead follow the Code and the regulations to determine whether the disputed gain is effectively connected income.

The court echoed arguments that have been made in numerous articles criticizing Rev. Rul. 91-32 since its release over 25 years ago. The Obama administration also tried to codify the result of Rev. Rul. 91-32, which could reasonably be interpreted as a concession that there was no statutory authority for Rev. Rul. 91-32 in the first place. Given the thrashing the IRS received from the court on seemingly every argument it made in the opinion, it is surprising that it has taken over 25 years for a court dismiss Rev. Rul. 91-32.

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